Treasury bull market shows few signs of ending

SERIOUS MONEY:The secular bull market in US treasury bonds that began way back in the autumn of 1981 has climbed a “wall of worry” for more than 30 years.

Myriad esteemed investment professionals have been embarrassed by their premature calls for an end to the seemingly relentless increase in prices that saw the yield on 10-year Treasuries drop from a peak of more than 15 per cent three decades ago, to below5 per cent by the turn of the new Millennium.

The extent of the downward move in yields appeared excessive to many but the collapse of the
dot.comequity bubble allowed the bull market to continue. And the mercantilist policies pursued by much of the emerging world throughout the robust global economic expansion that followed ensured that long-term interest rates were sustained at historically low levels.

Treasury bonds continued to reward contrarians, who ignored consensus opinion, through the early years of the new Millennium. Conservative portfolios performed even better when the financial crisis struck in 2007, as the yield on 10-year Treasuries sank from over 5 per cent pre-crisis to just 3.5 per cent by the time the Great Recession came to an end during the summer of 2009.

More than three years into recovery, and the Treasury bull market has displayed few signs of ending. Yields on longer maturities have slid by a further 200 basis points (two percentage points) to all-time lows, as the economic expansion struggles to reach escape velocity.

The market’s continued resilience has sparked concerns, however, that yields are been kept artificially low not only by central bankers’ commitment to hold policy rates near-zero for an extended period, but also via aggressive quantitative easing programmes.

Several investment practitioners believe Treasury bond prices are in dangerous territory, and argue that investors in these supposedly risk-free assets could well end up shouldering uncomfortable losses in the not-too-distant future. But do the bearish concerns stand up under close scrutiny?

The Federal Reserve’s commitment to hold policy rates at close to zero through mid-2015 is likely to have had some effect on Treasury bond yields, since long rates reflect expectations of future short rates. However, the greater decline in the yields available on longer maturities vis-à-vis both short- and medium-term notes – ie the reduction in the term premium – suggests that policy commitments have played only a minor role.

Several analysts conclude that the drop in the term premium can be attributed to aggressive central bank bond buying via the much-publicised quantitative easing programmes. However, analysis of the Federal Reserves holdings of marketable Treasuries reveals that its share, at about 15 per cent, is roughly the same as it was pre-crisis. Though its relative holdings of longer maturities has increased, almost 70 per cent of the outstanding stock is held elsewhere.

It is also clear that the drop in long yields to historic lows has not been unique to the US. The same trends are evident in several other advanced markets including Canada, Germany, Japan and Britain.

Further, the decline in yields across much of the developed world has occurred irrespective of whether quantitative easing has been employed as a monetary policy tool.

It is important to appreciate that the large decline in economic activity during the Great Recession was triggered by an unprecedented surge in the private sector’s demand for liquid assets that could be depended upon to provide a stable income stream at a time of declining or stagnant incomes.

The sudden need for insurance precipitated a surge in private sector savings relative to investment, and a plunge in government bond yields, as the large financial surplus sought out a safe home.

The American private sector directed its sizeable surplus primarily towards default-free Treasuries in order to avoid exchange risk, and the resulting currency mismatch between income and spending.

In the euro zone by contrast, no such exchange risk existed, but the absence of monetary sovereignty in member countries meant investment in the bonds of sovereigns with a fragile fiscal position could not be viewed as an effective hedge against difficult times. Not surprisingly, the euro zone’s private sector turned to Germany as the logical destination for safe haven flows.

Three years on and private sector savings remain high relative to savings by historical standards. This continues to underpin safe bond prices.

In the US for example, the private sector continues to run a large financial surplus of 5.5 per cent of GDP, which is more than three percentage points above the long-term average. Comparable figures are even higher elsewhere.

Meanwhile, the supply of safe assets has been unable to keep pace with the strong demand in recent years. The expanding production of private label safe assets via the securitisation of risky assets, helped to satisfy robust demand in the years that immediately preceded the crisis, but their high ratings subsequently proved unfounded.

Deteriorating fiscal positions and the euro crisis have also led to a reduction in the supply of public safe assets.

Record low bond yields across several advanced markets have sparked concerns that an accident is in the making. However, high private sector financial surpluses, alongside supply shortages, suggest a material sell-off is not likely until there is a material improvement in income growth expectations.

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